A brief history of the auditing profession

With the increasing complexity of accounting arose the need for ensuring its accuracy, and this in turn fostered the rise of the audit function. Modem auditing relates to the credibility or assurance of the second type of accountability. The exception is tax auditing which adds credibility to the first type of accountability. Tax auditing is the older form of auditing. It was extended in historical times to accountability of nobles or regional officials to the head of government, whether they were the chief nobles, kings, or an emperor. In these cases the subordinate official is not a provider of capital but is accountable for resources they have been delegated to administer. However, it can be viewed as the second type of accountability if the king is viewed as the provider of the resources to the administrator.

The second type of accountability can also arise in mercantile enterprises in which an entrepreneur provided with capital by others must give an account of how the capital was used.

The earliest examples of auditing seem to be from Ancient Egypt where the Pharaohs had two accountants maintain separate sets of records from the same sources of information. If the two independently created sets of records did not agree then the Pharaohs knew something was amiss. The first auditors were thus accountants who maintained an independent set of records of the same activities. If the two sets of records did not match, the penalties for the record-keeping accountants could be severe.

As the complexity of record keeping further increased, two sets of records became uneconomical and the second accountant increasingly independently monitored the work of the first accountant. When the first accountant reported (usually) orally the results of the record keeping, the second accountant “heard” this report and commented on its accuracy. So the term auditor conies from the Latin for “to hear” and this practice was continued from Ancient Persian times to the Middle Ages, through to today’s auditors when they attend the annual shareholder meetings.

By the time of Ancient Athens, accounting was being connected to political accountability in the first democracies. “In contrast to oligarchies—in which the powerful few ruled and there was no system of the 2nd type of accountability accountability—democratic Athens had the first such system of accountability” (Soli 2014, 3). Early in the Roman Empire there was a similar system of accountability also implemented by public accounting officers. Every public accounting officer had to submit a full accounting of funds received, including gifts.

Augustus was the first Roman emperor to make public the Empire’s financial assets along with his political achievements such as public works in the form of road building, free bread for Roman citizens, circuses, and expanding the Empire. This public accountability of the second type was limited to some degree by the toleration of fraud and briber}' of public officials, especially by the Roman emperors. Interestingly, this type of toleration continues to the present day in the form of weaknesses in accounting and audit practice. With the fall of Rome and the advent of the Dark Ages in Europe, this second type of accountability disappeared and rulers were answerable only to deities, as in the earliest agrarian times.

After 1000 ce, with increased centralization of state power and the formation of modem nation states, revival of trade, and re-adoption of coinage, society looked to universal religion in the form of the Church and to Ancient Roman precedents for guidance. Thus auditing and accounting were revived initially primarily in terms of the first type of accountability, as illustrated by the Domesday Book.

However, where trade was the dominant source of economic activity such as the North Italian city states of Venice and Genoa, record keeping for the second type of accountability became increasingly important and developed rapidly. The independent merchants of these city states were interested in calculating the worth of their trade. Using new technology introduced from Asia such as the abacus, Arabic numerals, and advances in arithmetic, the double-entry system of accounting evolved. A major advantage of this system is that it provided an internal check for fraud. When combined with the printing press and writing in modern languages, the first formal theory of accounting and detailed description of the double-entry system was published in 1494 by Pacioli (Gleason-White 2013, 74—75 and ch. 4). The auditors who heard these reports also had to keep up with these changes in accounting practice. This was necessary' to maintain accountability. Thus auditing and accounting are to some degree non-separable if the accountability is to be maintained. This will be an important theme to which we return in Chapter 11. The importance of integrating auditing with accounting theory has been suggested since at least 1961, and this can have an impact on how both accounting and auditing standards are implemented.

Within 40 years of its publication Pacioli’s bookkeeping was spreading throughout Europe. It was natural for the calculation of profit for any size business entity, down to each line of merchandise. It allowed improved decision making. By the 18th century business accounting had developed cost accounting to assist in managing production costs, labor, and product pricing so that manufacturing became increasingly profitable, innovative, and competitive. Entrepreneurs also needed to measure returns on capital investment. This was not possible unless one could ascertain whether a new piece of machinery was making a return (Soli 2014, 123). Some see this as a prerequisite to the rise of the modem business corporation (Gleason-White 2013, 123).

Increased accountability also spread to government accounts, first in Holland, then in France, and finally Britain. The second type of accountability for government was enshrined in Article 1, Section 9 of the United States Constitution, probably due to the influence of previous government accountability events in Europe.

The South Seas Bubble of 1720 illustrated the danger of the corporate form of organization with limited liability. It was not until accounting could reliably distinguish between contributed and earned capital that Ponzi Schemes like the South Seas Co. and similar bubbles could be deterred and the corporate form of organization could flourish.

But advances in technology and development and sophistication in capital markets created new challenges in accounting and their audits. In the 19th century the issue of the proper level of depreciation and maintenance in large capital projects like railroad investments could be effectively monitored, paving the way for more informed investment, initially during the mercantile period (roughly 1550—1770) and subsequently during the Industrial Revolution that followed and spread from Great Britain, then the U.S., Europe, and Japan, and to the rest of Asia (1770 to the present day). Despite recurring failures throughout the 19th century accounting came to be viewed as a civilizing force in society, and this helped foster the growth of the modern auditing firms (Soil 2014, ch. 11).

The modem auditing profession began in the first half of the 19th century in Britain. The UK Companies Act of 1844 required directors of public companies to carry out recordkeeping accounting and be verified by persons other than the directors. This Act required auditors to present “a full and fair balance sheet” indicating the earliest formal use of fair presentation (Brydon 2019, 57). Watts and Zimmerman (1983, 626) maintain that “Parliament was merely incorporating into law a version of a practice that had existed for six hundred years.” By the 1840s the Deloitte, Price Waterhouse, Ernst, and Touche accounting firms had begun in Great Britain. Their main tasks initially were to perform trustees in bankruptcy work in conformity with bankruptcy laws. By the second half of the 1800s, however, certified auditors were increasingly performing independent audits of financial statements. From 1879 to 1947 U.K. auditors used the expression “true and correct” (ibid., 29) and their reports have been required to state “true and fair” under UK Company Law since 1947 (ibid., 57). Brydon (2019, 58) is now calling for a change to the wording “present fairly in all material respects” consistent with much of the rest of the world. As the U.S. economy and capital markets grew in the latter part of the 19th century, British investors called on British auditors to audit U.S. company financials. British firms soon set up permanent offices in the thriving U.S. market. As American capital markets matured, an American profession developed following the British model.

The American profession became established in the last two decades of the 19th century. The first national U.S. accounting firm was opened in 1883 and the U.S. profession grew rapidly thereafter (Previts and Merino, 144). The profession also began to actively organize in this period in securing legislation, developing university programs in accounting (most, if not all, the major U.S. business schools were started by accountants), and establishing credentials for public practice (Previts and Merino 1998, 149).

The first Certified Public Accountant (CPA) law was passed in the state of New York in 1896, but there had been a system of self-regulated certifications based on experience and entrance exams for a dozen years prior to this legislation (ibid., 139). Other states followed and by the mid-1920s the CPA designation had become widely recognized as the credential to practice public accounting in the U.S. (ibid., 144).

During this period audits consisted of checking for bookkeeping errors and fraud. There were few internal controls and little understanding of the need for division of duties. Fraud was common and investors increasingly demanded periodic reporting that summarized the changes in the asset position of a firm (ibid., 130). By 1899 the New York Stock Exchange required periodic reporting on a regular basis (ibid., 131). By 1900 American accounting and auditing theory' and practice had surpassed that of the U.K.

The Companies Act of 1900 in the U.K. and the SEC Acts of 1933 and 1934 in the U.S. required annual audits by licensed auditors of all public companies in these countries. This began the rise of the major public accounting firms for the rest of the 20th century. By 2018 the profession was dominated by the Big 4 of PWC, E&Y, KPMG, and PMM. These firms originated in the U.S. or U.K. and their influence has spread globally. But as these firms become more global, they may encounter rivals in the future based on other cultures and socio-economic backgrounds.

The Big 4 firms generally have the best reputations for performing audits, but the source of this reputation is controversial. Is it because of size and global reach and because they have the biggest clients? Is it because they can provide a full range of services: consulting, tax advice, as well as auditing around the world for the largest multinational firms? Is it because they provide audits that are higher quality? We will explore the issue of quality audits in the rest of this book.

The growth of the profession’s reputation occurred despite numerous scandals over the years. This is sometimes referred to as the expectations gap representing society’s expectation of the role of auditors and what role auditors actually manage to achieve. The current profession has been associated with recurring scandals over the decades and the concept of the expectations gap indicates how the profession is perceived as failing. Spectacular perceived audit failures are a recurring theme, most recently in reference to a failure to warn financial statement users of problems at major financial institutions just before the financial crisis of 2008. The problems appear to be systemic. Criticisms of the auditors involved in Lehman Brothers and National Bank of Scotland have been particularly sharp. Before that was the spectacular failure of Arthur Andersen in 2002 following perceived audit failures at Enron and other major bankruptcies that created more extensive monitoring of the profession and took away the power of audit standard setting from public companies. These crises have further raised questions about the overall role of auditing in the economy (e.g., see the debate between DeFond et al. 2018 and Palmrose and Kinney 2018). A prime source of the expectations gap appears to be failure to detect fraud or predict failures at companies such as Enron, WorldCom, and Lehman Bros.

Some fault for the failures lies in the lack of proper incentives, either through weakness in the legal system, particularly the legal liability regime, or regulation (Honigsberg et al. 2019). There is evidence of regulatory capture of regulations by the profession (Gleason-White 2013, 216). Regulatory capture is a form of government failure that occurs when a regulatory agency created to act in the public interest instead advances the commercial or political concerns of special interest groups that dominate the industry or sector it is charged with regulating (Wikipedia, “Regulatory capture”). More generally, there is concern about how the accounting profession is affecting society as a whole, from calculative approaches to measuring various activities in government to the fact accounting and auditing can represent an ideology about representing social issues of many types (Gleason-White 2013, 253). This is captured by the notion of audit societies in which auditors play an increasing social role in expansion of monitoring activities, but many consider this expansion problematic (Power 1997). Currently, the U.K. Financial Reporting Council (FRC) indicates that all of the U.K.’s top auditors failed to meet quality targets for a second year in a row and particularly “failed to challenge management sufficiently on judgmental issues” (Sustainalytics, Governance in Brief, July 18, 2019, at sustainalytics.com/corporate-govemance-research-and-ratings). Audit quality requirements expect to be heightened in 2020/21. Furthermore, the Brydon Report (2019) calls for corporate auditors to take more responsibility for detecting fraud, provide greater transparency on the audit process, and create a new audit profession with a core set of its own principles.

We doubt that audit problems are limited to U.K. auditors. Further evidence of the need to address the issue of the auditor’s role is the continuing decline in the relevance of audited financial reporting in the U.S. that is extensively documented by Lev and Gu (2016) and Lev (2018). There is thus significant evidence that auditors may need to reconsider their role in the audits of financial statements.

Changing auditor responsibilities are perhaps most concisely captured by the frequent changes in audit and accounting standards. An overview of these changes is provided in the next section.